On September 30, 2013, the SEC threw the book at a small U.S. based accounting firm because of a deficient audit of a Chinese reverse merger that had found its way onto NASDAQ. The auditor, New Jersey based Patricio and Zhao (P&Z) and partner John Zhao, have been banned from auditing U.S. listed companies for three years.
The audit in question was for Keyuan Petrochemicals Inc. which had completed a reverse merger and later upgraded its listing to NASDAQ. It has since been kicked off of NASDAQ and is traded on the pink sheets. P&Z was its initial auditor. According to the 2010 PCAOB inspection report on the firm that was issued in 2012, P&Z audited 12 U.S. listed companies.
On January 17, 2011, Keyuan fired P&Z and hired KPMG. After the accounting frauds began to appear in mid-2010, many U.S. listed Chinese companies tried to upgrade auditors to the Big Four to provide confidence to skittish investors. Many of those “upgrades” did not end well for anyone. More often than not, the Big Four firm was unable to complete an audit, leading to the delisting of the company. That appears to have been the case here.
KPMG resigned on May 20, 2011, having not issued a report. KPMG discovered a number of related party transactions and discrepancies in reported cash balances. KPMG was replaced by Denver based GPH Horwath, yet the company was still kicked off of NASDAQ.
The SEC charged P&Z for a failed audit, focusing on the failure to identify and disclose related party transactions despite many red flags. P&Z and John Zhao are banned from auditing public companies for three years, which should put the auditor out of business. Other clients of P&Z will have to find new auditors.
The PCAOB’s inspection report of P&Z looked at three engagements and identified a long list of deficiencies that indicated that the firm “had not obtained sufficient competent evidential matter to support its opinion on the issuer's financial statements”. Yet, until yesterday, the firm continued to audit U.S. listed companies. And it was the SEC, not the PCAOB, which pulled the plug on P&Z.
The wheels of justice turn slowly – often too slowly to protect investors from shoddy audits. PCAOB rules protect auditors from disclosure of PCAOB enforcement actions so we don’t even know if the PCAOB was in the process of jerking P&Z’s registration. That is bad for investors. Congress needs to remove these restrictions and allow the PCAOB to warn the investing public of substandard audits.